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The 7 Best High-Dividend Mutual Funds

In a world where the average large-cap stock pays a 2% dividend yield, many investors whose goal is to generate more income are turning to high-dividend mutual funds. But not all funds are created equal; those with the highest yields often subject you to the highest risk, and some of the highest-paying funds are doling out capital gains rather than dividends.

These are the seven best high-dividend mutual funds on the market today, offering yields that are 20% to 90% higher than the average yield of the S&P 500.

Columbia Dividend Opportunity Fund

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This actively managed fund puts yield first and foremost, stating quite clearly in its strategy overview that it seeks to give its investors a "high level of current income," with a secondary objective of growing income and capital over time.

It looks for companies with high yields and the capability to grow their dividends, strong dividend histories and balance sheets, and the ability to sustain earnings and free cash flow generation. In simple language, it's a fairly standard dividend mutual fund. It generally seeks to yield about 50% more than the S&P 500, a level that is achievable without undue risk.

The Columbia Dividend Opportunity Fund is a high-yield blue-chip fund at its core. Top income stocks like AT&T, Philip Morris International, and Altria Group comprise its three biggest holdings, and about 17% of the fund. It's yielding about 3.8% at the time of writing, nearly twice what the S&P 500 yields.

No standout star, the fund has simply kept pace with the S&P 500 over the last 10 years, but more of its return comes in the form of yield, which income investors may prefer.

Vanguard High Dividend Yield Index Fund

Those who like simplicity will like what the Vanguard High Dividend Yield Index Fund has to offer. Its managers make a list of all U.S. companies of meaningful size, throw out real estate investment trusts (REITs) as well as companies that don't pay dividends, and then rank each remaining company by dividend yield. Finally, they invest in the highest-yielding companies that make up 50% of the aggregate value of the remaining list.

This results in a large-cap-dominated fund of more than 400 dividend-paying companies, and a yield about 50% higher than that of the S&P 500 index. The beauty of this fund lies in its diversity and low cost, as its annual expense ratio of 0.16% ensures that the vast majority of the income it generates goes to investors rather than the portfolio managers. Thanks to its luscious dividend yield, the fund has kept pace with the S&P 500 Index over its history.

Fidelity Equity Income Fund

This fund sets out with the goal of generating an above-average yield, and roughly matching the market's return with lower volatility. It invests primarily in dividend-paying large-cap stocks, and considers the Russell 3000 Value Index its benchmark.

The K class shares yield about 2.4%, roughly 20% more than the S&P 500, helped by a focus on high-yielding financial stocks like JP Morgan Chase, energy giant Chevron, and consumer staples stocks likeProctor & Gamble. Its top 10 holdings -- all household names -- make up about 28.5% of the fund by assets, but about 5% of the fund by the number of unique holdings. (It held 195 securities at the time of this writing.)

A low expense ratio of 0.51% of assets makes it attractive among actively managed funds, but for it to be a top contender, performance will have to improve; its returns have lagged the market in recent years.

Vanguard Equity Income Fund

One of Vanguard's few actively managed mutual funds, this one operates under the direction of Wellington Management and Vanguard's internal crew of macro analysts. Benchmarked to the same FTSE High Dividend Yield Index as the aforementioned Vanguard High Dividend Yield Fund, it seeks to generate above-average yields from a portfolio of stocks that also offer capital appreciation potential.

Performance has been excellent, outpacing the S&P 500 over the most recent 10-year and 15-year periods. Over the last 15 years, it compounded its investors' capital at an annualized rate of 7.8% vs. 6.9% for the S&P 500. A yield that is consistently higher than the large-cap index underlies its outperformance.

Low costs are a big part of what makes this fund so attractive. An annual expense ratio of 0.17% for its Admiral shares is lower than many index funds charge. And its recent yield of about 3% bests the S&P 500 by 50%.

Columbia Contrarian Core Fund

This fund isn't a dividend fund by mandate, but it does frequently hold higher-yielding companies. The Columbia Contrarian Core Fund is managed by bargain shoppers who look for companies they believe have been unjustifiably sold off at low valuations. The fund has a preference for financial services and healthcare stocks; roughly 38% of its portfolio comes from these two sectors.

The fund's record is worthy of study: It posted a 10-year average annualized return of 9.4% vs. the S&P 500's 7%. Importantly, its focus on cheap stocks seemed to help it out in 2008, when it declined by a slightly smaller degree than the broader market.

The fund's expense ratio of 0.65% per year is pricier than other dividend-focused funds, and its turnover of 60% is higher than other actively managed funds, and certainly higher than dividend index funds. Funds with higher turnover tend to create more taxable gains, and are probably a better fit for tax-advantaged retirement accounts. But this one is the star of our list, generating the highest historical returns despite higher expenses and greater turnover.

Sector Picks: Vanguard REIT and Utilities Funds

Neither the Vanguard REIT Index Fund nor the Vanguard Utilities Index Fund are true dividend funds, but they do focus on industries that pay the highest yields. Considering that there are few differences between sector index funds, it pays to shop the bargain bin -- and Vanguard's are some of the least expensive to own.

Real estate investment trusts must return 90% or more of their income to shareholders to avoid corporate taxation.The Vanguard REIT Index Fund holds 150 different REITs -- virtually every one of any practical size on the market today. Importantly, however, it avoids mortgage REITs, which invest in mortgages rather than real estate, and carry more risk than traditional equity REITs. A low expense ratio of 0.12% for its Admiral shares enables the fund to pay out a yield of about 3.6%, or roughly 80% higher than the S&P 500 Index.

The Vanguard Utilities Index Fund also happens to offer a beefy yield of 3.4% on its Admiral share class. It holds shares of 80 publicly traded utilities, of which many have paid consistent and growing dividends for years. Utilities, especially regulated utilities, frequently top the list of dividend achievers-- companies that have increased their dividends for 10 consecutive years or more. The fund's 0.1% annual expense ratio makes it an inexpensive way to grab a slice of one of the highest-yielding corners of the stock market.

Before piling into REIT or utilities funds for high yields, be mindful of their risks. Sector funds are undiversified by definition, and frequently diverge substantially from the broader market. In 2013, when the S&P 500 surged by more than 32%, Vanguard's REIT fund returned just 2.4% including dividends, while its utilities fund returned just 15%. You wouldn't put your whole portfolio in tech stocks, and you shouldn't put all your savings in REITs or utilities in the pursuit of yield, either.

Why invest in high-yield mutual funds

History has shown us that dividend stocks outperform. A study by the American Association of Individual Investors found that from 1927 to the end of 2014, the highest-yielding dividend stocks generated an average annual return of 11.3%, compared to 9.3% for the lowest-yielding stocks, and 8.6% for stocks that did not pay a dividend at all.

Admittedly, any historical look at dividend-paying stocks measures performance in a period of generally declining interest rates, which makes dividend stocks more attractive.Whether dividend stocks can outperform in the the rising rate environment likely to prevail ahead remains to be seen, but there are logical reasons to believe that they can.

To pay and maintain a dividend, a company must be consistently profitable, and have good earnings quality,two traits of stocks that offer good long-term return potential.Companies that return cash to shareholders are also less likely to pursue big mergers or acquisitions, which typically turn out better for the acquiree than the acquirer. Over long periods of time, it seems likely that high-dividend mutual funds with low fees can outperform other funds while generating more income along the way.

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